If two independent, unrelated parties negotiate with one other for a transaction and eventually reach a price, a transaction in correct market price will take place.
The price at which the transaction occurs -- the arm's length price -- is preferred for tax purposes as it is a fair reflection of the value of the goods/ services. Both parties were acting in their own self-interest and were not subject to any pressure or duress from the other party.
But when two related companies engage in trade, the temptation to artificially lower the price at which the transaction takes place can exist.
It is intended to minimise the tax bills for both parties. Take, for instance, Company A, a food grower in Africa.
It processes its produce through three of its subsidiaries -- X (in Africa), Y (in a tax haven) and Z (in United States).
The finished product is then sold to the United States.
Now, Company X sells its product to Company Y at an artificially low price, resulting in low profits and low tax bills for Company X based in Africa.
Company Y then sells the product to Company Z at an artificially high price, almost as high as the retail price at which Company Z would sell the final product in the US.
Company Z, as a result, would register low profits and, therefore, low tax bills, just like Company X did in the previous stage.
Among all transactions, Company Y, located in the tax-free country, gains the most. Its high profits, unfortunately, cannot be taxed.
Company A, the owner of these subsidiaries, ultimately gains, getting away with paying very little tax.